This article explores common tax and accounting challenges that non-US businesses encounter when entering the US market. For many businesses, especially in the tech sector, expanding into the US can lead to rapid growth and significant opportunities. It’s crucial to establish a solid framework from the outset to avoid costly mistakes and excessive management efforts.
Navigating US tax regulations, which may be unfamiliar to international businesses, involves understanding new concepts and completing numerous forms. At Frazier & Deeter, we specialize in guiding businesses through this process to establish a robust and tax-efficient structure that maximizes market potential. While this article focuses on a UK company expanding into the US, the principles discussed are applicable to businesses from other countries.
Do You Need a US Subsidiary?
One of the first considerations when expanding into the US is whether you need to establish a subsidiary. If you’re merely selling to US customers with limited or no physical presence, a subsidiary may not be necessary. Often, the need for a subsidiary arises when hiring local employees. Even without a subsidiary, you may still have sales or state corporate income tax obligations. Additionally, having a physical presence or someone concluding contracts on your behalf in the US likely creates a taxable presence for federal corporate income tax purposes.
Once You Have Decided to Set Up a US Subsidiary
The creation of a US subsidiary will immediately bring you within the US tax net. The matters to be addressed can be divided between routine, including registrations, annual compliance and annual returns, and planning/advisory. For most businesses entering the US market, the main planning/advisory areas to consider are transfer pricing, state taxes (including Sales and Use taxes) and global mobility (the tax consequences of having people move to/from the US on short-term or long-term assignments).
The choice of entity in the US can have a bearing on your tax position and should be discussed with both your lawyers and tax advisors. The most common form of entity established by non-US parent companies is the Delaware incorporated C corporation. Note that the state of incorporation is not driven by tax considerations; it is a function of corporate law considerations. Other alternatives to the C corporation include a Limited Liability Company (“LLC”) and, on extremely rare occasions, an S corporation.
Obtaining an Employer Identification Number (EIN)
Once the company has been formed, the first thing to do is register with the federal tax authorities by applying for an EIN. The process is somewhat old fashioned, involving fax machines and special phone lines that are only open to registered agents. While the form is relatively straightforward, once submitted, it can take a while to sort out if any part of it is filled incorrectly. Obtaining an EIN typically takes a couple of weeks, and until you have it, you can’t open a bank account or set up payroll. The EIN also initiates your registration for federal and state income taxes, fully integrating your company into the US tax system.
Establishing Your Operating Model
The next step is to decide on your operating model for the US company. Will it be contracting with your customers in the US, or just be used to provide support services back to the parent company? Often the decision regarding which entity will be the contracting entity with the US customers will be driven by commercial and legal considerations. The choices you make will have an impact on the tax position.
At this stage, it’s important to consider the transfer pricing implications of your operating model. Transfer pricing rules in both the US and the parent company’s location will dictate how future profits and losses are allocated between them. This isn’t something to postpone until the group is profitable; the initial operating model will form the basis for future profit sharing. Often, the US expects a taxable profit allocation from day one, even if the group overall is incurring losses. Investing time upfront to decide and document your operating model, ensuring it meets both tax authorities’ standards, can prevent costly and time-consuming tax inquiries. It will also help establish an efficient tax strategy for your international expansion.
If you decide that your US company will be the contracting entity with your US customers, there are a number of decisions to be made about your operating model and the approach to transfer pricing:
- Will the US act as a full-risk distributor or should it be a limited risk distributor?
- Should it pay a royalty back to the parent company to reflect the intangible assets that have been generated there or would it be better to fix the remuneration for the US in some other way (for example, as a percentage of revenues or as a mark-up on costs)?
- Is the US entity acting more as an agent for the parent company?
Beyond deciding on the operating model and transfer pricing policy, there are two other key matters to deal with as part of this exercise:
- Firstly, whichever model is chosen there will need to be an exercise carried out to determine the pricing used. The IRS in particular are likely to insist on a benchmarking exercise for most intercompany transactions. This involves accessing specific databases of comparable pricing information so the pricing chosen for your transactions between the US subsidiary and the parent company can be justified.
- Secondly, you will need to get support from your lawyers in creating legally binding intercompany agreements. Without these, there is no legal basis for making the intercompany payments.
In an ideal world, the operating model and transfer pricing arrangement should be supported by OECD format transfer pricing documentation (known as a Master File and Local File). For smaller companies that are going international for the first time, it may be acceptable to leave this documentation until a later stage.
State and Local Taxes
Many are surprised to learn that the US tax system isn’t a single federal system. Each of the 50 states has its own tax system, and any of the 3,000+ counties can theoretically impose their own local taxes.
It is important to note that state and local taxes are not covered by double tax treaties. For example, if a UK company trades in the US and the UK/US double tax treaty assigns the right to tax those profits to the UK, this would exempt the company from US federal taxes but not state income taxes. This point can easily be overlooked. In practice, the main taxes that need to be considered at the state level are income taxes, sales taxes and property taxes.
State Income Taxes
State income taxes are typically in the region of 6% but can be as high as 12%. Most states will levy the tax on the same tax base (with some adjustments) on which the federal income taxes are charged, with the state primarily looking for an apportionment of the taxable profits. For example, if the taxable profits of the US company are $100 and 12% of the profits are deemed to be attributable to the state of Georgia, then the IRS will collect the federal tax on the $100 of profits and the state of Georgia will receive the state income tax on $12 of the profits. Other states may also get a share of the profits, but there is no requirement for the total taxable profits of all the states to add up to $100. Each state has its own way of deciding whether the taxable profits are linked to that state, which means the total could add up to more or less than the $100.
In the US, accountants often refer to “nexus” when discussing state taxation. This term indicates whether there is sufficient connection with a state to make profits taxable there. State income tax returns must be filed annually, separate from federal income tax returns. In theory, a company that trades extensively across the US could have many state income tax returns to submit each year. In practice, they tend to be much simpler returns than the federal income tax returns.
Sales Taxes
Sales taxes in the US are often compared to VAT or GST, but there are significant differences. Notably, you can’t recover input taxes as you can with VAT; any sales tax charged on a purchase is a cost to you. Additionally, there will be many instances where sales taxes are not due on a transaction. Sales taxes are typically only charged on sales of tangible, personal property to an end user, so if you are buying goods for resale or buying/selling services, there is unlikely to be any sales tax in the US. However, it is not always as straightforward, as roughly half the states in the US also treat SaaS (Software as a Service) as subject to sales tax.
If you are selling in the US, whether you are a US company or a non-US entity, then you will need to determine if you have sufficient nexus with a state for sales tax to be due. In the old days, this was mostly based on physical presence in the state; however, following the Supreme Court decision in 2018, known as the “Wayfair” ruling, states can force you to collect sales tax even if you do not have a physical nexus in that state. We now need to focus on the concept of “economic nexus,” which usually revolves around the value of sales you have made in that state in a particular year.
US customers usually expect quoted prices to exclude sales taxes, which are added at the point of sale. The trader is simply regarded as the collecting agent for the state tax authority. A common risk for new entrants to the US market is failing to collect sales tax on certain sales, only to have this issue uncovered during an enquiry. By then, it is too late to recover the tax from customers, making it a direct cost to the trader. Make sure you get good advice on your sales tax obligations up front to ensure you collect and remit any sales tax that is due.
Property Taxes
Many states impose a business tax on the value of a company’s tangible personal property (equipment, furniture, etc.) and include inventory in the tax base. Although these taxes often have exemptions or may not result in significant liabilities, it’s important to be aware of potential reporting requirements and related obligations.
Annual Tax Returns in the US
Federal corporate income tax returns are normally due three months and fifteen days after the end of an accounting period, but this deadline can be extended if requested. Companies are free to choose their accounting period in the US, but it is typically aligned to the accounting period of the parent company. State corporate income tax returns deadlines usually follow the federal due date.
Unlike the UK, where there is an annual requirement for companies to file financial statements at Companies House, there is no requirement in the US for private companies to prepare or publish financial statements. This means that your tax advisers in the US can prepare income tax returns based on either management accounts or a trial balance, either of which could be kept by your accounting team in the UK.
Franchise Tax
Some states in the US impose a Franchise Tax on companies that have nexus in that state. This is essentially an annual fee for the privilege of being able to do business in that state. For example, in Delaware, the Franchise Tax for “C corporations” is based on the number of authorised shares of the company. If there are 5,000 or fewer authorised shares then the annual fee is $175 and if there are between 5,001 and 10,000 authorised shares the annual fee is $250. The fees increase for companies with more than 10,000 authorised shares. Companies usually manage Franchise Taxes on their own, but if they have a presence in multiple states, they may hire a corporate agent to handle the returns.
Other Forms
There are many official forms which may need to be completed by companies doing business in the US. These include forms such as the W8- BEN- E, which may be required if you are trading in the US as a non-US company, or the form 5472, which is required for reporting particular activities with foreign related companies. Keeping track of various forms and their deadlines can be challenging, so it is important to work with an advisor who offers comprehensive support and informs you of any new requirements.
Mind the GAAP
The subtle differences between IFRS and US GAAP can lead to significant differences in revenue recognition. The introduction of ASC 606 in 2018 for public companies and 2019 for private companies changed the landscape for businesses in the technology sector. When you are putting together information for a tax return in the US, it is essential to start with the correct figure for revenue. It is also important to be on top of revenue recognition. If you plan to raise finance in the US, potential investors may quickly lose confidence if they discover errors in your revenue recognition approach.
Payroll Taxes
If you are employing people in the US, you will need to engage with a payroll services provider to operate payroll and handle payroll withholding taxes due to the IRS and state tax authorities. There are many capable payroll services providers that can do this, but none can start until the EIN has been obtained. If you have plans for setting up and hiring in the US, it is important to consider the timeline to ensure everything is set up in time.
Stock Options
As you expand your US operations, you may want to offer stock options to senior employees based in the US. It is perfectly acceptable to offer options over shares in the UK parent, but real care needs to be taken with the valuation of the options. A grant of an option at an undervalue can have significant tax consequences for the employees in the US. Many UK companies are unaware that the IRS has a significantly different approach to valuing options when compared to HMRC. The approach used by the IRS is known as a section 409A valuation and we always recommend that this kind of valuation is carried out before issuing options to anyone based in the US.
Global Mobility
Given the significance of the US as a market opportunity for many UK businesses, it is common for founders to want to spend time in the US or send over some of their senior UK team to ensure that they make the most of the opportunities there. This could be in the form of short-term business trips or a longer-term secondment or transfer. Besides sorting out the visas, there are a number of tax matters which need to be considered. Firstly, for the individual, will they be in the US long enough to become tax resident there and will they lose their UK tax resident status? What happens if they end up being tax resident in both countries? Which country will have the taxing rights? How would a temporary change of tax residence affect other sources of income or other assets which the individual might hold?
The companies will need to consider their policy for these employees. Do they want to compensate them for any additional tax charge which the employees will incur as a result of the relocation? The companies will also need to be aware of any reporting or payroll withholding obligations they may have for internationally mobile employees – whether they are going from the UK to the US or if you are bringing US employees to the UK for a short business trip. For example, in the UK, there can be a requirement to operate PAYE on an apportioned part of the salary of a business visitor from your US subsidiary, even if they are in the UK for just one day. This can be avoided by entering into a particular form of agreement with HMRC where the UK employer commits to providing certain information on overseas visitors on an annual basis.
Note that from the US standpoint, while the employee may not have a federal personal income tax return filing requirement, the company may still have payroll tax withholding requirements. If there is no federal payroll tax withholding requirement, there may still be a state payroll tax withholding requirement. Also, while the individual employee may not have a federal income tax reporting requirement, they may still have a state income tax reporting requirement. An early conversation with a specialist who is familiar with UK/US mobility can quickly identify any areas which need to be addressed.
Inversions (or the Delaware Flip)
Beyond the market opportunity, a key attraction of the US for UK companies is access to investors. Many investors prefer to invest in a US-based top company, so it’s necessary to establish a US entity above the existing UK company. Typically, this involves creating a new US company and having the UK company’s shareholders transfer their shares to the new US entity in exchange for shares in the US company. The new US company can then issue additional shares to new investors for cash. This process is known as an inversion or “flip.”
There are a number of tax considerations to understand regarding an inversion. Firstly, you will want to make sure that the inversion does not trigger a capital gains tax charge for the existing investors on their “disposal” of the shares in the UK company. Secondly, you will want to ensure there is no charge to stamp duty land tax on the restructuring. Both these objectives should be easy to achieve provided the right approach is taken. Future investors will be keen to ensure that they are not investing in a company which has a potential problem, so it is advisable to seek the appropriate clearances from HMRC on these matters to ensure the restructuring does not cause any problems during a future due diligence exercise by a potential investor or acquirer.
If the UK company has business angel investors who have benefitted from either Enterprise Investment Scheme (EIS) relief or Seed EIS relief then the inversion can be more complicated. It is still feasible to invert without the investor losing any of their valuable reliefs, but you will need to be much more careful with the restructuring to ensure everything happens in the right order. We strongly recommend working with an experienced law firm and accounting firm if you are considering an inversion.
Conclusion
For many businesses, the establishment of a US subsidiary will be their first step towards creating an international group. The tax complexities of setting up in the US are compounded by the combination of federal and state tax systems. The potential rewards from getting it right in the US are enormous for many businesses, but it is easy to fall short. If you don’t pay proper attention to all of the tax and accounting considerations when you enter the market, then it can be very costly and time-consuming to sort things out at a later date. A skilled firm of advisers can guide you through the process, addressing overlooked areas and responding to questions you may have.
When it comes to international expansion, a proactive approach is always best. The tax and business advisers at Frazier & Deeter can support businesses and employees with their international tax and accounting needs. We’d love to discuss your international growth; please contact one of our experts below to schedule an informal call.
About the Authors
Malcolm Joy is the leader of Frazier & Deeter’s UK practice, as well as the firm’s Transfer Pricing team. Mike Whitacre is a Tax Partner at Frazier & Deeter, based in Atlanta, GA, who works with many multi-national organisations.
Malcolm Joy, UK Managing Partner | malcolm.joy@frazierdeeter.com
Mike Whitacre, US Partner, International Tax | mike.whitacre@frazierdeeter.com